1. Economics 216: The Macroeconomics of Development Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA 94305-6072, U.S.A. Spring 2000-2001 Email: ljlau@stanford.edu; WebPages: http://www.stanford.edu/~ljlau

2. Lecture 9 The Role of Money and Finance Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA 94305-6072, U.S.A. Spring 2000-2001 Email: ljlau@stanford.edu; WebPages: http://www.stanford.edu/~ljlau

3. Lawrence J. Lau, Stanford University3 Why is Money Desirable? Money as a Facilitator of Transactions u It lowers transactions cost (and hence makes possible productive transactions that otherwise may not have taken place in the absence of an accepted medium of exchange) A common unit of account--a common numeraire u Non-coincidence (lack of synchronization) of supply and demand—barters, and successive barters, can only take place at a single time and place (e.g. Samuelson’s “exact consumption loan” model) u The effect of credit-worthiness and risk--lack of mutual trust requires cash on delivery (a future delivery on barter is risky) u The benefits and costs of anonymity (non-discrimination; illegal activities, the cash-in-advance constraint) u Private versus public issuance of money u Currency substitution and the network externality--the more a form of money is accepted, the more it is acceptable

4. Lawrence J. Lau, Stanford University4 The Different Definitions of Money u M0 = currency and coins in circulation u M1 = M0 + demand deposits u M2 = M1 + savings deposits u The distinction between demand deposits and savings deposits has become blurred in the United States (interest and non-interest bearing, withdrawal notice and penalty, money market funds at non- banking institutions)

5. Lawrence J. Lau, Stanford University5 The Demand for Money u Three traditional sources of demand for money (M1) u Transactions Demand u Precautionary Demand u Speculative Demand

6. Lawrence J. Lau, Stanford University6 Transactions Demand (1) u The types of market transactions requiring money balances u The monetization of previously non-market transactions (barter, home consumption, home services, in kind payments of rents and wages) u Inter-firm transactions (market) versus intra-firm transactions (non-market)-- the organization of the economy (the degree of vertical integration; the degree of concentration (conglomerates), the degree of specialization and division of labor, the degree of self-sufficiency) u Transactions involving goods and services currently produced (thus generating current-value added) and transactions involving existing physical assets and inventories (which do not generate current value-added) u Real transactions versus financial transactions--purchases and sales of business assets versus purchases and sales of shares of common stock (securitization facilitates the trading of assets and hence increases the volume of transactions (reduces lumpiness and enhances liquidity) u The multiplier effect of financial transactions (financial deepening)--mutual funds, derivatives, holding companies u The volume of trade in existing assets, real or financial, depends on the level of wealth rather than the level of real GNP or GDP

7. Lawrence J. Lau, Stanford University7 Transactions Demand (2) u The role of institutions, customs and practices u (e.g., the frequency of settlement (a higher frequency requires more money, other things being equal), the use of credit and debit cards (increases the GDP/Money Supply ratio), the use of sweep accounts (increases the GDP/Money Supply ratio), the demand for money under central planning) u The cost of holding money for transactions purposes is the time value of money (the real rate of interest)

8. Lawrence J. Lau, Stanford University8 The Quantity Theory of Money (Friedman): MV = PT u For the four variables, only M and P can be directly observed u V cannot be directly observed, but is measured as PT/V u T actually stands for the total real volume of transactions in the economy but in general cannot be directly observed either u T is frequently identified with real GDP (value added), Y and is typically assumed to be proportional to Y (real GDP), T=  Y, where t is a constant u The velocity of money, defined as V=PT/M, is in general assumed to be an increasing function of the real rate of interest (the velocity is so-to-speak “the number of times money needs to change hands in order to support the given volume of transactions”) u V is in general not constant, even with the rate of real interest constant—V tends to rise with innovations in finance and transactions technology; e.g., a shift from the use of cash or checks to credit cards and debit cards reduces the money balances required to support a given volume of transactions and hence increases V

9. Lawrence J. Lau, Stanford University9 The Measurement of the Velocity of Money u V as defined cannot be measured because T is not directly observed u Instead, one can define an alternative velocity variable V*=PY/M in terms of observable variables, which is referred to as velocity* u V*= PT/M x Y/T = V x Y/T = V/  u The variable  =T/Y the ratio of the total real volume of all transactions T to real GDP Y is not a constant but changes over time u The volume of transactions relative to real GDP (T/Y) tends to rise in the process of economic development u T/Y also rises with financial deepening u T/Y rises with rising volume of trade with the same trade surplus/deficit u For most developing economies, especially in the early stages of their economic development, T is likely to rise much faster than Y, and hence  is increasing over time; for developed economies,  is likely to be more stable. u Since both V and  tend to rise over time and with economic development and growth—what is likely to happen to V*? u At the beginning phase of economic development, V, which depends on financial and technological innovation, is likely to increase very slowly, whereas  is likely to increase quite rapidly, leading to a fall in V*; as an economy matures, Increases in V become much more important, and  becomes relatively more stable, and V* is likely to rise

10. Lawrence J. Lau, Stanford University10 The Velocity of Money: China and the United States of America

11. Lawrence J. Lau, Stanford University11 The Implications of the Quantity Equation of Money: MV* = PY

12. Lawrence J. Lau, Stanford University12 The Rate of Change of Velocity*

13. Lawrence J. Lau, Stanford University13 The Usefulness of the Quantity Equation of Money: MV* = PY u The usefulness of the quantity equation of money is greatly diminished if the velocity* of circulation of money is variable u For most developing countries, especially those without a history of high or hyper-inflation, the rate of growth of money supply can be significantly higher than the rate of growth of real GDP without necessarily causing additional inflation u This is because the velocity* of money, defined as PY/M, has, on the whole, been declining (a given level of real GDP requires more money balances to support over time)

14. Lawrence J. Lau, Stanford University14 The Velocity of Money and Real GDP per Capita

15. Lawrence J. Lau, Stanford University15 The Rate of Growth of Money Supply and Real GDP per Capita

16. Lawrence J. Lau, Stanford University16 The Rate of Inflation and Real GDP per Capita

17. Lawrence J. Lau, Stanford University17 Precautionary Demand u Availability of social (or even private) insurance (e.g., retirement, survivor, health care, unemployment, inflation)--degree of completeness of markets u Availability of credit (households and firms) u The time value of money (the rate of interest)

18. Lawrence J. Lau, Stanford University18 Speculative Demand u Money balances maintained for the exploitation of unexpected opportunities u The time value of money (the rate of interest)

19. Lawrence J. Lau, Stanford University19 The Degree of Monetization and Growth of Real GDP u The degree of monetization increases with economic development u Measured GDP may grow faster than true GDP especially at the early stage of economic development u Examples u Marketization of barter transactions u Marketization of household work u Growth of financial transactions--financial deepening

20. Lawrence J. Lau, Stanford University20 Seigniorage and Inflation Tax u The central bank (or private banks) issuing the currency in circulation has seigniorage to the extent that money balances are held solely for the purpose of transactions or as a store of value u In developing economies, inflation is sometimes deliberately used as an instrument of taxation

21. Lawrence J. Lau, Stanford University21 The Role of Finance (Credit) as a Facilitator of Transactions u The “Cash-in-Advance” Constraint u There are transactions that would not have taken place in the absence of finance or credit, formal or informal u Asymmetric information between savers and entrepreneurs/investors u Transfer of risks from savers and producers to financiers (e.g. letter of credit) u Economies of scale u Maturity transformation u Pooling of resources (lumpiness of investments) u Pooling of risks across borrowers u Transaction costs u Specialization in information acquisition and monitoring u Amelioration of exchange rate risk u Lack of alternative investment instruments for savers

22. Lawrence J. Lau, Stanford University22 Explicit or Implicit Deposit Insurance u Enhances confidence in and hence stability of the financial system u Reduces the probability of bank failure due to illiquidity as opposed to insolvency u Reduces the spillover (contagion) effect of bank failure u Levels the playing field between large and small banks (a large number of small banks is not as efficient as a small number of large banks because of the intrinsic economies of scale in banking; however, the political economy may favor a large number of small banks) u Encourages moral hazard on the part of both depositors and owners of financial institutions u Prudential regulation and supervision are therefore required u A high reserve ratio as a substitute for ineffective prudential regulation and supervision

23. Lawrence J. Lau, Stanford University23 Moral Hazard and Financial Institutions u The capital requirements (e.g., the Bank for International Settlement (BIS) standard of 8%) are generally too low to discourage moral hazard on the part of the owners of the financial institutions u Government-directed credit and the doctrine of “too big to fail” encourage moral hazard on the part of the borrowers (as well as lenders) u Explicit or implicit deposit insurance encourage moral hazard on the part of savers and depositors in their choices of depository institutions for their deposits u Informal credit markets (the lack of anonymity which limits moral hazard) u Mutual credit associations u Grameen banks

24. Lawrence J. Lau, Stanford University24 The Rate of Interest on Savings Deposits and Real GDP per Capita

25. Lawrence J. Lau, Stanford University25 The Rate of Interest on Loans and Real GDP per Capita

26. Lawrence J. Lau, Stanford University26 The Interest Rate Spread and Real GDP per Capita

27. Lawrence J. Lau, Stanford University27 The Interest Rate Spread and Real GDP per Capita

28. Lawrence J. Lau, Stanford University28 The Interest Rate Spread and Real GDP per Capita

29. Lawrence J. Lau, Stanford University29 The Rate of Interest on Savings Deposits and the Lagged Rate of Inflation

30. Lawrence J. Lau, Stanford University30 The Rate of Interest on Loans and the Lagged Rate of Inflation

31. Lawrence J. Lau, Stanford University31 The Rate of Inflation and the Rate of Economic Growth (1970-1998)

32. Lawrence J. Lau, Stanford University32 The Effectiveness of Monetary Policy u Setting the basic or reference rate of interest (e.g., the federal funds rate, the rediscount rate) u Setting the capital requirement (BIS standard) u Setting the reserve ratio u Inflation targeting u Open market operations (the lack of a deep and liquid bond market)

33. Lawrence J. Lau, Stanford University33 Financial Repression u Is there financial repression in developing economies? u Is financial repression desirable or undesirable?

34. Lawrence J. Lau, Stanford University34 The Benefits and Costs of a Currency Board System (Dollarization) u True dollarization (Panama) and quasi-dollarization (Hong Kong, Argentina) u True dollarization implies that the U.S. dollar will be legal tender for all obligations and contracts can be denominated in U.S. dollars u Hong Kong and Argentina with a fixed U.S.$ peg are not quite truly dollarized but is very close to being so u Indonesia considered adopting a currency-board system in the midst of the East Asian currency crisis

35. Lawrence J. Lau, Stanford University35 The Benefits and Costs of a Currency Board System (Dollarization) u Benefits: u Insulation of economy from exchange rate volatility u Credible pre-commitment to non-interventionist monetary policy, in particular, non-inflationary financing of government expenditures u Implicit commitment to a low rate of inflation (a rate of inflation similar to that of the United States)—lowers inflationary expectations if credible u The rate of interest and the rate of inflation will be at U.S. levels if credible u Promotes long-term FDI as well as foreign portfolio investment u Facilitates foreign trade u Costs: u No more monetary policy (neither money supply nor interest rate can be independently controlled) u Fiscal policy constrained by the ability to issue local currency or US$ denominated government notes and bonds u Loss of seigniorage from currency issuance under true dollarization

36. Lawrence J. Lau, Stanford University36 The Currency Board System u Adequate foreign exchange reserves, in excess of M0, will still be required u Even a completely cashless society, which implies M0 = 0, will still require foreign exchange for the smooth and orderly conduct of business u Flexibility (especially downward) of prices and wage rates is essential for prompt and successful adjustment to external shocks u Low stock of external (especially short-term) debt denominated in foreign currency relative to foreign exchange reserves

37. Lawrence J. Lau, Stanford University37 Outstanding Issues of Dollarization u Outstanding issues u Is there a lender of last resort (to domestic financial institutions)? u Can the seigniorage be shared (true dollarization)? u Coordination, if any, of monetary policy with the U.S. (e.g., monetary union)? u The U.S. benefits from seigniorage, both direct and indirect

38. Lawrence J. Lau, Stanford University38 Voluntary Virtual Dollarization u In economies with a high rate of inflation and a continuously depreciating currency, it is quite common for transactions (e.g., loans and interest) to be denominated in U.S. dollars but settled in terms of the local currency in accordance with the exchange rate (either the official market rate or the black market rate, as specified by prior agreement) u Example 1: A firm may place an order in terms of U.S. dollars and upon delivery will settle in local currency in accordance with the market exchange rate on the date of delivery u Example 2: A firm may borrow money in terms of U.S. dollars. It will be given the proceeds in terms of the local currency in accordance with the market exchange rate on the date of the loan draw down. Upon maturity, it will repay in terms of the local currency in accordance with the exchange rate on the date of maturity.